Submission to Utilities Commission on PWC Networks Pricing ... · Submission to Utilities...

Submission to Utilities Commission

on

PWC Networks Pricing proposal: 2014 Regulatory Reset

UC Draft Decision and PWC Revised Proposal

March 2014

N.T. Major Energy Users: Networks Pricing Proposal: 2014 Regulatory ResetResponse to draft decision and revised proposal

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TABLE OF CONTENTS

Page

EXECUTIVE SUMMARY 3

1. Introduction 5

2. An overview of the PWC proposal in light ofpast decisions 6

3. Forecasts 10

4. The Regulatory Asset Base (RAB) 15

5. Forecast capex 18

6. Forecast opex 23

7. Service performance 30

8. WACC 31

9. Revenue and pricing outcome 33

10. Other issues 35


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EXECUTIVE SUMMARY

The Northern Territory Major Energy Users (NTMEU), on behalf of the larger energy

users in the Territory, welcomes the opportunity to provide its comments on the draft

decision by the Utilities Commission (UC) on the Power and Water Corporation (PWC)

application to increase its electricity network charges, and the revised application from

PWC responding to the draft decision.

The revenue sought by PWC in its initial and revised applications and the UC draft

decision impose a massive revenue shock on consumers as the following chart shows.

Source: PWC applications, UC decisions

With a modest (if any) increase in demand or consumption, the entire step increase will

apply to PWC prices converting the revenue shock into a price shock of similar magnitude.


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The cause of the UC decision to agree with such a large price increase has been the

inability of PWC to manage the networks efficiently in the past, and the UC is complicit in

the PWC passing onto consumers the costs of its poor performance.

In addition to the high debt risk premium used to generate the WACC, it is that aspect of

the opex allowance that is driving the excessive increase in the revenue proposed for PWC

activities. The UC consultant (PB) has clearly identified that PWC is operating well

outside of efficient performance levels and suggested that a considerable reduction in opex

by at least a quarter is needed to bring PWC opex closer to the average performance of

PWC comparators. In this regard, it must be highlighted that reaching the average of all

comparators does not mean that PWC would be operating at the efficient frontier, but

considerably well above it. The UC has the responsibility for only allowing opex revenues

that are efficient and not the much larger amounts claimed by PWC or even allowed in the

draft decision.

Rather than setting an efficient opex allowance, the UC has only imposed on PWC an

efficiency impost of about 2% pa which PWC has rejected. The NTMEU considers that the

UC has not paid sufficient attention to the benchmarking work by PB and by not doing so

will cause consumers considerable harm.


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1. Introduction

The Northern Territory Major Energy Users (NTMEU) welcomes the opportunity to

provide comments on the draft decision by the Utilities Commission (UC) on the

application by Power and Water Corporation (PWC) for increases in its regulated revenue

allowance for its electricity network.

NTMEU comments are provided below on the draft decision and the PWC networks

revised regulatory proposal. The NTMEU expects that the comments provided will be

considered along with the comments made in the response to the initial PWC proposal.


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2. An overview of the PWC proposal in light of past decisions

2.1 PWC revenue for AA4 compared to historic revenue

The flowing chart shows the additional revenue the PWC is seeking and what the UC draft

decision will impose on consumers compared to what the current revenue allowance is.


Overall, both the revised application and the UC draft decision impose a nearly 50%

increase in the PWC Network revenue. This massive increase in revenue is despite the UC

consultant's (PB Strategic Consulting) assessment that PWC is not efficient and it is the

NTMEU view that PWC has operated inefficiently in the past and seeks to continue to do

so by essentially seeking to operate on a cost plus basis for the next regulatory period.


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The reports provided by PB show that it had considerable difficulty in analysing PWC

historic data and this has led to extreme difficulty in identifying where PWC costs are

inefficient.

The price shock that consumers will see as a result of the PWC claims and UC review do

not reflect what would be expected from an efficient network service provider. Yet the UC

seems to be prepared to accept such a massive hike in allowable revenue.

2.2 Historic performance of PWC

During the current period (AA3) a number of reviews have highlighted that PWC

Networks has not been operating as an efficient network service provider. In particular, the

Davies report was extremely critical of the PWC approach to maintenance of its

substations and recommended considerable change. In particular, Davies recommended

that condition monitoring of plant should be implemented. PWC advises that the Davies

recommendations have now been put into practice but advises that the full effect of these

changes (PWC page 18) "...will not be seen for some time."

During the current period (AA3) PWC has significantly exceeded the allowances for opex

and capex and at the same time allowed service performance to deteriorate. The reporting

by PWC of its historic costs displays such inexactitude that PB, the UC consultants, (a firm

well experienced in regulatory reviews) has found it extremely difficult to make sense of

the reporting provided by PWC. This lack of clarity and consistency has aided PWC in

arguing for increased costs which the consultant had difficulty in justifying when carrying

out benchmarking studies.

What is obvious is that consumers are expected to carry the costs for PWC inefficiencies

and ineffectiveness and by agreeing that PWC needs to be supported in improving its cost

management the UC is complicit in supporting such a process. It is not in the long term

interests of consumers that consumers should be required to pay for the past historic

incompetence that PWC has displayed.


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2.3 Transition to NEM rules and regulation

It is clear that the UC sees the AER is developing a good suite of tools to enable better

regulation of monopoly assets such as the PWC electricity network. The NTMEU

considers that this move will be beneficial for consumers.

As mentioned in other parts of this submission, the NTMEU considers that PWC is

operating on a cost plus basis and appears to consider that consumers should be required to

not only pay for past PWC mistakes, but to continue to pay for services well in excess of

what is an efficient allowance.

One of the key changes that the AER is now implementing, is improvements to

benchmarking for opex and capex. This means that in addition to assessing the efficiency

of actual past performance, it will also test the efficiency of the forecasts of opex and

capex to ensure that efficiency is improving with time, as is expected. The NTMEU sees

that this approach will provide confidence in the allowances provided throughout the

regulatory period.

The NTMEU expects that UC will use these AER approaches and tools to assist in

assessment of what are efficient allowances for PWC.

2.4 Fee based power factor correction

The NTMEU agrees with the UC and its consultant PB regarding the implementation of a

penalty for power factor. The PWC approach imposes not only a charge based on kVA but

a penalty for not achieving a set level of power factor as well. A charge based on kVA

already requires users with a low power factor to pay for the usage a low power factor

imposes on the network, so to impose a penalty as well is double dipping and should not be

supported.


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The NTMEU recognizes that for users paying for services based on their consumption

(kWh) it is difficult to identify what their power factor is at any point in time. The concern

the NTMEU has is that without universal demand based metering (such as a smart meter)

there will always be customers that have a worse power factor than that set under the

distribution code but identifying those that do have such a poor power factor will be "hit

and miss". So for every customer identified with a power factor lower than that set in the

Code, there will be others that are not identified. Equally, those with a power factor above

the limit will not be rewarded for doing so, providing a disincentive to maintain their good

power factor.

This means that:

Those with a low power factor will only be punished if they are identified and it is

not clear how PWC will identify such transgression. Such a mechanism is open to

misuse.

Those with a power factor higher than that set in the code will not be incentivised

to maintain it and will receive no reward for having a better power factor

The NTMEU supports the UC in rejecting this proposed change.


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3. Forecasts

3.1 Demand and consumption

With the use of a revenue cap regulatory control, the forecast of future consumption is less

important than under a price cap approach. However, the forecast of changed peak demand

is a key driver of forecasts of capex

PWC provided its forecasts for demand which show that demand in Darwin-Katherine and

Alice Springs will increase faster than the current trend for standard weather maximum

demand (SWMD) and in Tennant Creek will remain static. The UC commissioned its

consultant to assess the likely growths of demand and consumption to assess the

reasonableness of the PWC forecasts and determined that lower forecasts were more likely

to occur than those forecast by PWC. The PWC revised proposal rejects the UC

consultant's view and the adjustments made by the UC.

In light of the conflicting views, the NTMEU sought advice on the issue from user groups

with which it is affiliated. The advice received is that great care is needed to assess

forecasts of growth as the experience from other jurisdictions is that networks have

consistently overstated expected demand and consumption and this has resulted in

consumers having to pay considerably more than needed whilst the networks garnered

considerable benefits from lower than expected forecasts. The fact that AEMO has again

recently reduced its forecasts for demand and consumption in the NEM from those

forecasts made late last year1 implies that the current trend of falling demand and

consumption is not seeing any reversal as implied by PWC.

The impact of over-forecasting can have considerable impacts on allowances made in the

building block approach to revenue setting. For example, for AA3 commencing 2009,

Essential Energy in NSW claimed a considerable amount of augmentation capex on the

1 See http://www.aemo.com.au/News-and-Events/News/Supply-Demand-Snapshot-February-2014


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basis of expected growth. In practice its capex program shows considerable under-run on

the allowance as a result of growth being considerably less than forecast. The actual capex

is shown in the following chart

The bulk of the capex not used related to augmentation projects not required because of

lower than predicted demand and, as a result, Essential garnered a massive benefit

approaching $200m over AA3 in not using its capex allowance that it had argued earlier

was essential due to growth. What is also important was the observation that although

augmentation capex was considerably less than allowed by the regulator, Essential

overspent on replacement capex.

The NTMEU affiliates comment that the lesson to be learned is that under the present

environment where electricity use is declining for a number of reasons (eg increasing roof

top PV driven by the renewable energy target, a high $A reducing local demand and

tourism, high electricity prices driving lower consumption, etc) there is a real risk that

networks will overstate their expectations and cause consumers unnecessary costs.


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Another factor which was identified by NTMEU affiliates is that government owned

networks (such as PWC) have an incentive to over invest as the regulator awards a return

on capital which is much higher than the cost of borrowing by the network. This results in

the network overspending on capex giving the network (referred to "gold plating" by

Garnaut in his report update #8) the ability to reward its government owner with higher

dividends from the arbitrage between the cost of capital it is awarded by the regulator and

the cost of capital it pays to its related Treasury Corporation2.

The NTMEU noted in its response to the initial PWC proposal that it had a view that the

forecasts for demand and consumption were overstated based on analysis of historic trends.

The NTMEU sees that PWC disagrees with the UC forecasts and maintains that its original

forecasts are correct - AEMO made a similar assertion in November 2013 and yet has

revised that forecast considerably downwards only four months later. Equally, the UC

effectively observes that, as the issue of the forecasts has only a bearing on the amount of

capex to be allowed, it becomes a moot point other than to ensure the augmentation capex

is adjusted to reflect probable needs as assessed.

The NTMMEU considers that as PWC has an incentive to overstate the forecasts, the

views of the independent reviewer for the capex (PB) should carry more weight than those

of PWC.

3.2 Real labour cost increases

PWC stated its increases in labour costs are related to its Enterprise Bargaining Agreement

(EBA) and to the Deloitte Access Economics (DAE) real labour price index (LPI)

forecasts. The UC has accepted the proposed real price escalation of labour as proposed by

PWC.

2 The Annual Report for PWC implies that it pays about 5.2% on its borrowings yet the WACC sourced byPWC seeks a cost of debt well above what it pays


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The NTMEU is quite concerned that the UC has accepted the PWC proposal unchallenged.

In its response to the PWC proposal, the NTMEU expressed its concerns about the use of

the PWC Enterprise Bargaining Agreement as the basis for escalating its labour costs and

that general labour productivity improvements must be included as part of using labour

price indices.

The UC has not commented at all on these issues and has allowed PWC to negotiate its

own labour cost adjustments and to pass these onto consumers unchallenged and neither

has the UC addressed the need for increased labour productivity other than the need to

bring the opex allowance to reflect benchmarking analysis.

The PWC labour cost escalation table 7.1 highlights the concern the NTMEU has with

accepting the use of an EBA rather than independent labour price indices. In real terms,

internal labour for the PWC will increase by 7.2% over AA4 yet external labour will

increase by only 5.6%. There is no justification for PWC direct labour to increase by so

much over the cost of external labour, accepting the premise that labour costs in the

Territory exhibit higher premiums than perhaps apply in the southern states.

The NTMEU considers the UC has been remiss in not addressing either of these two issues

and should rectify the omission in its final decision.

3.3 Real material cost increases

As with the real labour cost increases, the UC accepts the PWC assertions about real

material cost increases. In its response to the PWC proposal, the NTMEU stated that the

weightings for the different elements of the material price movements needs to be explicit

and that these should reflect the build up of the capex proposals for them to applied

correctly.

NTMEU comments that without the weightings being made explicit, it is possible for the

networks to "game" the real price escalation process so that the weightings vary access


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arrangement on access arrangement so as to provide the highest real price movement in

materials. That this is a real issue is supported by the recent moves by the AER in its new

guidelines to establish materials weightings for the "notional electricity network" and apply

this in a consistent manner. This will overcome the concern that the weightings are varied

by networks in order to maximise the benefits that accrue from materials cost escalations.

In its response to the PWC application, the NTMEU raised other concerns on real price

movements for materials that have been ignored by the UC.

The NTMEU considers that the UC needs to carry out a better evaluation of the material

cost escalators.


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4. The Regulatory Asset Base (RAB)

PWC re-priced its regulatory asset base (RAB) by reassessing the depreciated optimised

replacement cost (DORC) of its assets. It then compared this to the roll forward model used

previously by the UC and determined that the re-pricing approach is more beneficial to it than the

roll forward model used.

The UC has accepted that the re-DORC-ed approach to setting the RAB is acceptable on the basis

that (page55):

1. The difference between the two estimates is small

2. The UC had concerns that the original RAB value was based on a flawed assessment of the

RAB determined in 1999

.

3. The SKM assessment3 of the asset base provided greater granularity for the PWC asset

base and is apparently more transparent, detailed, and reliable and provides a more stable

base for future determinations.

The NTMEU notes that, although the UC determined that the RAB in 2002 was assumed to be

$350m, the new value is now assumed to be fixed at $930m, an increase in of 165%. If there was

an error in the setting of the 2002 estimate, the subsequent changes that have occurred in the RAB

mean that the error in 2002 would be miniscule.

The NTMEU considers that the UC has erred in accepting a "re-DORC-ed" estimate of the RAB

when it is widely accepted that a DORC estimate is inaccurate in itself and open to error and abuse.

This is why all other regulators use the roll forward approach because it is much a more transparent

than any DORC approach which is beset by estimates and assumptions. The NTMEU finds it

concerning that the UC considers that the use of a DORC approach is transparent - it is not, the roll

3 What is not stated is that in its report to the UC 19 September 2008, ACIL Tasman stated (page 7) that itsassessment of the RAB at $350m at 2002 resulted in a 24% lower RAB than the SKM re-DORC-ed valueassessed in 2007


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forward approach is much more transparent as it assesses the actual capex added and the

depreciation allowed on a clear set of principles. For the UC to state that a reason for accepting the

"re-DORC-ed" value is that it is more transparent than the roll forward approach is manifestly

incorrect.

To put the RAB into context, the RAB at the start of AA2 was $372m and at the start of AA3

was forecast to be $512.8m4 a 37.8% increase. At the end of AA3 the RAB will be

$916.35m (Table 7.2 in UC draft decision) which is a further increase of 78.7%, double the

previous rate of increase. This increase in RAB bears almost no relationship to the

expansion of the network to meet increased demand and implies that some of the capex in

AA3 could well be not prudent and/or not efficient. The decision of the UC to accept the

re-DORC-ed asset base does not assess whether the past capex was prudent or efficient.

This lack of review for prudency and efficiency also applies the RAB roll forward approach used

but at least when a RAB roll forward approach is used, the regulator has the ability to assess

whether actual capex was prudent and efficient. The UC has tacitly accepted that the actual capex

meets the criteria for rolling into the RAB. However, as the NTMEU noted in its response to the

UC at the last revenue reset, the UC consultant (ACIL Tasman) observed in its report to the UC

(page 7) that it had not carried out an efficiency audit of the past and current capital expenditures.

This means that no assessment has been made of the prudency of the PWC capex since 2002 when

the RAB was first established.

There is such concern about automatic roll in of capex, that the new NEM rules require assessment

of actual capex for efficiency should the actual capex exceed the regulatory allowance as applies

for AA3. This means that an ex post review of capex would be required in the current instance

under the new NEM rules as PWC has exceeded the capex allowance. Under the NT rules, capex

has to be demonstrably prudent but the use of a re-DORC-ed RAB precludes the UC assessing

prudency of actual capex.

In contrast to the UC reasons for accepting the DORC valuation, the NTMEU considers that:

4 See ACIL Tasman report to UC 19 September 2009 table 2


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1. The difference between the two values is significant as it will increase the costs consumers

have to pay for the services provided both now and into the future, and that it will provide

PWC with an additional 2% on its return on capital for the next 40 years or so.

2. ACIL Tasman in its report to the UC in 19 September 2008 demonstrates clearly that

readdressing a DORC value rather than the roll forward approach introduces a

considerable premium to the RAB (see page 3)

3. Even if the 2002 decision had some errors in it, the massive increases in the RAB

subsequent have rendered any errors made at that time virtually negligible

4. Whilst greater granularity is provided, this is not a reason to increase the RAB as the

granularity can be provided without inflating the RAB to a new DORC value. To assert

that the process is more transparent flies in the face of decisions made by other regulators

which clearly consider the use of the roll forward model is much preferred because of its

transparency.

The NTMEU does not agree that the UC should inflate the RAB based on a new assessment of the

PWC RAB using the DORC methodology.


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5. Forecast CapexPWC has forecast it will require capex of $322.96m for AA4. The UC draft decision trims

this to $265m but PWC considers the UC has erred and that the allowance should be

$292m. The following chart puts these three assessments into context with historic capex.


Capex is primarily driven by the need to augment the network to reflect greater demand, by

an increase in customer numbers and by the need to replace assets that are no longer able

to reliably perform their function.


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The bulk of the draft decision adjustments to the capex claimed by PWC reflect a reduction

of some 20% off the augmentation capex and 17.5% of the replacement and reliability

capex.

What is concerning is that the bulk of the capex proposed by PWC for AA4 is for

replacement and reliability, with these two categories comprising 60% of the capex sought.

NTMEU affiliates have seen a similar trend with applications from other networks, where

capex identified for augmentation at the last revenue reset is transferred to replacement and

reliability capex, resulting in an overall increase in capex used for replacement and

reliability. This has provided an argument for the increase in replacement and reliability

capex at the next revenue reset.

The AER has identified this trend and is proposing to establish a need for replacement and

reliability capex based on asset lives with condition monitoring reports providing a

moderating influence. The reason for this is that there was a trend for replacing assets

when fully depreciated (and therefore not generating a return on assets) even though the

assets were still "used and useful". Condition monitoring reports also provide support for

replacing assets that have deteriorated faster than the expected lives.

In its revised application, PWC considers that the UC has erred in reducing the

augmentation capex as the forecasts for growth used by the UC underestimate the likely

growth and because there are errors in the transition of the UC consultant views into the

UC draft decision. The NTMEU does not have sufficient data to be able to comment on the

detail of the recommendations to defer specific projects but relies more on the overall

historic approach to assessing capex and what has occurred elsewhere to provide a high

level view on the reasonableness of the PWC claims.

PWC comments that it has reviewed the detail provided by the UC consultant (PB) and

addresses each recommendation of PB on a project by project basis. Effectively, PWC Has


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assessed its capex from a "bottom up" approach and argues specific details for each

project.

NTMEU members and others operating in a competitive environment cannot operate on

such a "bottom up" assessment basis as they have their capital limited; commonly

decisions are made at Board level to set a total amount of capex regardless of the claims

made by management for capital for specific projects. The NTMEU considers that the UC

should take a similar approach to that of a firm's Board and set a maximum capex level

based on what capex is available from retained earnings. The NTMEU accepts that the UC

had difficulty in identifying what allowance had been provided for capex in AA3. Despite

this, the UC has carried out a creditable effort in back casting a capex allowance.

PWC revised forecast is that its RAB will be $1087.3m at the end of AA4 (table 12.1 PWC

revised proposal). This means that over a 10 year period, the PWC RAB will have doubled.

This, at a high level, implies that, overall, the amount of capex has been excessive.

However the detail of where capex was used in the current period is essential when

assessing what is a reasonable allowance as capex is devoted to a number of different

categories. Knowing the categories and how much capex has been dedicated to each is

important when assessing future capex needs as past capex in each category assists in

assessing future claims. For example replacement capex, compliance capex and reliability

capex all reflect a continuum and show (or should show) a year on year consistency.

Augmentation capex is driven by the forecast of demand and should reflect this trend.

In the NTMEU examination of the draft decision, PB provides a table of actual and

estimated capex under a number of different categories. This is useful in analysing where

capex has been used, and when, and how this matches with the PWC forecasts.


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The table shows that during AA3 augmentation capex reduced as it was realised that the

forecast growth was not being observed in the market. To offset the decline in

augmentation capex in AA3, PWC started to increase replacement capex, well above the

trend of the earlier years with replacement capex estimated to peak in the final two years of

AA3.

Forecast augmentation capex reflects the trend of the last years of AA3 where demand is

seen to reduce well below that implied by the AA3 forecast growth pattern. It would

appear that the forecast augmentation capex for AA4 reflects the reality of lessening

demand.

In contrast, the NTMEU is intrigued that replacement capex and reliability capex show

such significant variation year on year, such that it appears that PWC is using the

opportunity to imply that replacement and reliability capex should be increased above

historical levels. Replacement capex for the first 3 years of AA3 averaged $23.9m pa and

was estimated to average $47.8m pa for the remaining two years reflecting a reducing

amount of capex used for augmentation. This implies that the driver for the replacement

capex was more related to lower augmentation capex required rather than a need to replace

assets at the end of their useful lives.


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Consumers expected that the large amount of replacement and reliability capex would have

resulted in better service performance yet service standards have not reflected the amount

of replacement capex provided What is concerning is that despite the amount of excessive

replacement and reliability capex, consumers are getting worse service rather than better.

The average replacement capex for AA4 is $30.3m pa with much of it front loaded. The

PWC approach to replacement capex shows that they are seeking an increase of over 25%

above the actual average recorded for the first three years of AA3 supporting a view that

the forecast replacement capex appears to be excessive.

A similar observation can be made regarding compliance capex which has seen a doubling

of cost between AA3 and AA4

The NTMEU considers that the reduction in capex included by the UC in its draft decision

is to be welcomed, but still appears to be inflated for replacement capex and probably

compliance capex.

The claim by PWC to increase the capex allowance above that allowed by the UC draft

decision does not seem to be justified on a global view. The NTMEU is concerned that

PWC arguments are all based on a "bottom up" approach which is recognised as a

technique for increasing claims.

The UC has offered PWC the use of "contingent projects" which PWC has accepted -

allowing for contingent projects transfers risk from the network to consumers. What is an

essential element of contingent projects is that it is recognised that there will be timing

issues for projects and on those projects dependent on significantly changed conditions.

The NTMEU considers that providing the ability to introduce contingent projects should

result in a reduction in claimed capex as the risk to PWC is reduced. However, PWC seems

to think that they are entitled to both an unnecessarily high capex allowance and contingent

projects.


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6. Forecast opex

PWC has forecast it will require a revised opex allowance of $528.1m for AA4. It has

rejected much of the opex reduction considered by the UC to be appropriate. The following

chart puts the three forecasts (initial, draft decision and revised) into context with historic

opex. The opex allowed by the UC draft decision is also shown.


PWC is still forecasting a further increase in its opex needs for AA4 by some 10% more

than it actually used in the last years of AA3. Further, the PB assessment of the opex and

maintenance claims highlights some major inconsistencies, both in terms of benchmark

performance and in the breakdown of the various sub elements that make up the opex

budget.


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In its response to the PWC application, the NTMEU noted that, at a high level, for opex to

be some 50% of the total revenue, highlights an aspect of concern because comparatively

opex is usually closer to 30% of revenue across a range of comparator networks. PB has

carried out a detailed assessment of PWC opex to identify why this anomaly occurs.

Such a large increase in opex is also at odds with the age of the network. In the past 10

years the RAB has increased from $372m at the start of AA2 to $916.35m at the end of

AA3 - an increase of 2.5 times. At the same time the network has not expanded by

anything like this due from increases in demand and consumption. The impact of this

increase in RAB is effectively to reduce the average age of the network considerably. A

network with a young average age should require less opex than one of the same size but

older. Despite this large reduction in age, opex has increased and the UC has indicated that

an increase in opex is what consumers should pay.

The NTMEU considers that the opex allowance is too high.

6.1 Breakdown of sub-elements and category analysis

In its response to the PWC application, the NTMEU was extremely critical of PWC in that

it did not provide a detailed breakdown of the opex that it was claiming or of the historic

performance in each of these categories. The NTMEU is pleased that PB has carried out

this analysis and in its report provided the following detail


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This longitudinal analysis of the sub elements provides some interesting facets on the

claim for AA4. PB was able in some areas to identify some sensible explanations for the

significant changes between the historical and the forecast costs but not in every case.


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The lack of certainty as to allocation of costs, the insufficient data collection and

granularity and ability to relate costs to reliability all conspire to prevent a sensible

comparison to identify how a base-step-trend approach to opex setting can be achieved.

However, despite these shortcomings, the detailed analysis provided by PB is welcomed as

it provides some explanation as to why the PWC claim for opex is so out of sync with its

comparators.

The criticisms levelled at PWC by PB are most concerning in that these have allowed

PWC to seek and effectively obtain allowances that reflect a cost plus approach to setting

the opex rather than setting allowances that are efficient. The UC expresses similar

concerns in its draft decision to those of PB.

What is absent from the UC draft decision is a requirement that PWC must provide more

accurate data provision so that future reviews have the benefit of a better dataset. In this

regard the NTMEU notes that under the Better Regulation program the AER requires NSPs

to provide much more accurate data on direct costs incurred. If the UC is similarly required

to provide such data then this will provide support to the analysis needed at the next reset

review.

6.2 Benchmarking

The benchmarking carried out by PB supports the category analysis it completed by

identifying that PWC is not efficient (contrary to the PWC assertion from the Huegin

analysis) and that PWC needs to be driven a considerable way just to meet the average of

its comparators.

A high level benchmark is to assess the relative costs of the main revenue drivers and the

NTMEU identified that PWC opex is not efficient based on the relativities between the

opex for different electricity NSPs as a percentage of revenue. Typically, opex is ~30% of

the total needed revenue yet in the case of PWC, opex is ~50% of revenue. The detailed

benchmarking analysis by PB supports this high level assessment.


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Implicit in the PB analysis is that labour costs for PWC should reflect a 30% premium to

costs to those applying elsewhere. This is cited from one source only (Rawlinson's

construction costs for the Territory compared to those in Adelaide) but there is no other

source provided for comparison. The NTMEU considers that the UC should seek a wider

source of input data to assess the NT premium for costs so that such moderating inputs can

be applied in the future with greater confidence.

The NTMEU is a little critical of the PB benchmarking analysis on the basis that it focuses

on a limited number of inputs/outputs. The NTMEU would have hoped that PB would

have looked at other well used benchmarking tests such as overhead as a proportion of

revenue as well as those suggested in the Economic Insights report to the AER5 as part of

the AER Better Regulation program on benchmarking.

Whilst the NTMEU accepts that the work by PB on assessing the variation between

benchmarking (including its further analysis in its letter 4 December 2013) reflects the

time available for the task, the NTMEU is aware that the AER has introduced a

comprehensive approach to energy network benchmarking. The NTMEU considers that the

UC should require PWC to join into the AER benchmarking program and to provide the

necessary data to the UC and AER so that more holistic benchmarking can be carried out

in the future.

What the analysis by PB and the UC also overlooks is that benchmark of the average of the

PWC comparators is not the benchmark for the efficient frontier and PWC should only be

provided with efficient costs rather than the average of its comparators. This means that the

decision by the UC to "glide path" PWC efficiency to meet the average of its comparators

does not mean that PWC costs will then be efficient - what it means is that PWC will be at

the average of comparator costs.

5 Available at http://www.aer.gov.au/sites/default/files/Economic%20Insights%20report%20-%20Economic%20benchmarking%20of%20electricity%20network%20service%20providers%20-%2025%20June%202013.PDF


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If the full value of the opex reduction of 27% implied by the PB benchmarking was

instituted then opex would be about 40% of the total revenue allowed by the UC in its draft

decision. Adjusting this further by removing the 30% cost premium PB identified for being

located in the Territory would bring the opex allowance back to about 35% which is within

keeping of where it would be expected opex would be relative to revenue. This adds

credibility to the opex reduction implied by the PB benchmarking.

The NTMEU is also concerned that the UC proposes to allow PWC an extended time to

reach the comparator average efficiency. Despite PB identifying that PWC is at least 27%

above average opex (page 5 of the PB "further analysis letter") the UC proposes that PWC

only achieve a 10% improvement in opex over AA4 to bring it closer to efficient levels.

The NTMEU considers that a 2% pa improvement in efficiency means that consumers will

be paying for PWC inefficiency for a considerable time.

The NTMEU also notes that PWC rejects this expectation in its revised application and

refers to additional advice from its consultant Huegin. At the heart of the Huegin response

on benchmarking (PWC Attachment 10) lies the argument that PWC has no peers for it to

be benchmarked against. The NTMEU notes that Huegin provided a similar view to this to

the AER as part of the Better Regulation benchmarking program and the AER made it

quite clear they did not agree with Huegin on this aspect - the AER pointed out that there

are more areas of commonality than there are differences.

The NTMEU points out that an efficient provider in a competitive environment would

have to address its inefficiencies in a much shorter time than 5 years or go out of business.

For the UC to allow PWC to reduce its opex inefficiencies by just a third and to be allowed

to do this over 5 years imposes on consumers an unnecessary cost premium.


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This high level assessment reinforces the benchmarking conclusions carried out by PB that

PWC allowances for opex are excessive, and need to be significantly reduced from those

allowed in the UC draft decision.


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7. Service performanceThe UC has already set service performance targets for PWC with specific levels for

System Average Interruption Duration Index (SAIDI) and System Average Interruption

Frequency Index (SAIFI) set as targets for PWC to achieve based on SAIDI and SAIFI

measures.

The historical performance of PWC has shown that PWC has generally not met service

performance targets in the past and could have difficulties in meeting the improved

standards set for AA4. PWC provides data indicating that it expects service performance

will generally under-perform the targets for much of AA4.

The NTMEU considers that the UC should couple the new service performance targets

with an incentive (such as the Service Target Performance Incentive Scheme - STPIS) that

the AER has successfully used in the NEM to assist PWC in achieving the enhanced

service performance expected. Such a scheme would reward PWC for out performance (ie

pass onto consumers increased costs for better service) and penalise it for

underperformance (ie allow consumers to pay a lesser amount for lesser service).


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8. WACCIn addressing its claim for a weighted average cost of capital (WACC) allowance, PWC

identified a mix of past UC practices coupled with some past AER practices (as used for

Aurora - the distribution network in Tasmania) along with some of the recent AER Better

Regulation activity currently in draft guideline stages to develop its WACC allowance.

The UC has reverted to the approaches used by regulators prior to the recent changes to the

NEM rules and the more recent AER guidelines. The following table lays out the various

parameters used in the PWC revenue reset process to date and adds in more recent data

from the AER final decision on SP Ausnet Victorian Transmission revenue reset.

Parameter PWC initialUC draft

decision

PWC

revised

AER FD on

SP Ausnet

Nominal risk free rate 3.89% 4.13% 4.31%

MRP 6% 6% 6.0% 6.5%

Equity beta 0.8 0.7 0.7 0.8%

DRP 4.11% 3.00% 3.00% 2.48%

Gearing 60:40 60:40 60:40 60:40

Inflation 2.60% 2.51% 2.51% 2.45%

Tax rate 30% 30% 30% 30%

Gamma 0.25% 0.25% 0.25% 0.65

Pre tax nominal WACC 8.80% 8.12% 9.05%

It is recognised that the MRP, equity beta and gamma applying to SP Ausnet result from

the AER WACC decision in 2009 applies only to transmission networks and therefore

values used more recently should be implemented. What is important to note is that the

AER final decision on debt risk premium (DRP) was calculated at 2.48%, a significant

reduction to the DRP used by the AER in the SP Ausnet draft decision which the UC


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considered was appropriate. Following the approach used by the UC for the DRP (and

accepted by PWC), the NTMEU considers that the actual DRP value used by the AER for

the SP Ausnet final decision should be used for the PWC final decision. Even so, this

decision will get a considerable benefit by using this value as PWC will still be paying well

below the implied cost of debt of ~6.6% as it currently pays just over 5%6.

The NTMEU considers that the UC should adjust the risk free rate to that applying in the

averaging period before the final decision is made, use the agreed parameters for MRP,

equity beta, gearing and gamma and implement the more contemporary value for DRP

used in the AER final decision rather than value used in the AER and UC draft decisions.

6 The Annual Report for PWC implies that it pays about 5.2% on its borrowings


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9. Revenue and pricing outcomeIn its initial application PWC sought a step increase in its revenue of 57.2% followed real

increases of 1% pa thereafter as shown in table 44. By the end of AA4, PWC seeks a real

increase of over 63%

The PWC revised application (table 15.2) marginally reduces the unsmoothed revenue

sought (particularly in years 4 and 5) , reduces the step increase in year 1, significantly

increases the step increase in year 2 and then maintains a real increase each year thereafter

of 1% pa. This results in a cumulative increase by the end of AA4 of some 78%.

The UC draft decision (table 15.7) reduces the allowed revenue and sets a step increase of

over 43% followed by real increases of 1% pa for the other four years resulting in the final

year revenue being some 49% above the current revenue.


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Regardless of the approach used (ie the initial proposal, the draft decision and the revised

application proposal), the NTMEU considers that the step increase in year 1 provides a

massive price shock to consumers and questions whether this is what consumers would

want or can afford.

The NTMEU considers that if the UC considers that PWC should receive such a large

increase in allowed revenue of about 50% (and the NTMEU considers that something is

drastically wrong if such a massive step increase is considered appropriate) then it would

be preferable for annual increases to be more consistent.


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10. Other IssuesPWC sought to expand its ability to "pass through" additional costs that it considers it

might be exposed to during the course of AA4. The NTMEU expressed concerns with the

extent of the pass through provisions that are sought over above those allowed by the UC

of the 2009 decision.

The UC was specific in its draft decision as to what it would permit as a "pass through" yet

PWC has sought to expand its ability to pass through costs to consumers. The only

additional "pass through" provision that should be allowed is if and when the NT

government separates retail and generation from PWC networks. Even in this instance,

PWC networks must quantify what the additional costs it incurs are rather than provide an

estimate of them

The UC has also introduced the concept of contingent projects. To a degree this should

offset the amount of ex ante capex allowed to PWC. The UC has set strict conditions on

what the trigger must be (including limits on materiality) and the NTMEU supports the UC

decision in this regard. At the same time, the NTMEU considers that the PWC request to

reduce the materiality limits should be rejected because if the limits are set too low, the

concept of contingent projects loses effect and allows many more projects to be included as

contingent projects. In this regard the NTMEU points out that firms operating in the

competitive sector do not have such an ability for "contingent projects". This is a result of

capital available for projects is limited so if a new project needs to be implemented than

existing projects have to be reprioritised with deferral or even exclusion of previously

allowed projects being the result.

The pricing methodology used by PWC was an issue the NTMEU raised in its response to

the initial application. The NTEU points out that pricing methodology used for electricity

distribution is currently under review by the AEMC as it is recognised that the current


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pricing approaches used by distribution networks is flawed. The NTMEU attempted to get

greater detail on pricing by PWC but this has not been enforced by the UC.

The NTMEU also notes that pricing in transmission networks is also under review with

NSW's TransGrid leading a review process.

The NTMEU considers that the UC must look into the issue of pricing in much greater

detail to ensure that pricing is reflective of the costs each customer incurs. Without this

certainty of cost reflectivity, inefficient outcomes are likely to occur.

Submission to Utilities Commission on PWC Networks Pricing ... · Submission to Utilities...

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